Venture debt provides a capital injection to bolster growth and extend operating runway. Find out if this investment vehicle is right for your startup.
For tech startups looking to secure funding in today’s challenging economic environment, venture debt (VD) is increasingly seen as a potential source of financing. In 2022, the venture debt market in Canada totalled $664 million, up from $500 million 2021. While equity is often the primary source of funding for startups, venture debt can be a complement to venture capital due to its unique benefits for early-stage companies. But how do you know if, and when, venture debt is right for your business?
This article covers the basics on venture debt financing, including:
- What is venture debt?
- How venture debt differs from equity
- The value of venture debt
- How venture debt financing is structured
- What venture debt lenders look for in a startup
- What to consider when choosing a venture debt provider
What is venture debt?
Venture debt is a type of loan offered by select banks and non-bank lenders. Unlike traditional commercial loans, venture debt is specifically designed for early- to growth-stage companies. The quality of the relationship with the VD provider and the terms offered can vary significantly as there is no one-size-fits-all approach to venture debt, but it shouldn’t saddle a scaling business with a disproportionate amount of interest. Choosing the right lender is essential as not all VD providers are created equal, nor do they all provide true venture debt.
Venture debt vs. venture capital
Similar to venture capital, venture debt provides a capital injection to a startup to bolster growth and extend operating runway. There are also important differences, and understanding them is essential to creating an optimal capital structure for your company.
Venture debt can be a way to supplement an equity round without directly impacting the cap table.
Debt does not dilute company ownership, whereas equity capital does. Venture debt can be a way to supplement an equity round without directly impacting the cap table. However, keep in mind venture debt often includes a nominal warrant position which may impact company ownership, if exercised.
Venture debt is structured as a term loan that has principal and interest payments that must be paid within a specific time frame. Repayment of equity is typically not contractually required.
Venture debt sits at the top of the capital stack as it gets paid ahead of equity holders and carries relatively lower risk. Equity resides below debt in the capital stack as a claim on the ownership of the business.
How venture debt differs from traditional loans
Traditional debt has long been reserved for less risky and more stable enterprises that generate positive cash flow. Startups are IP-driven and cash-burning—and, clearly, don’t meet the prerequisites for a traditional loan. Venture debt offers an alternate option as it’s specifically designed to support the unique situation and needs of startups. In fact, a venture-backed company can sometimes access venture debt even at zero revenue.
While commercial loans are underwritten to cash flows or assets, venture debt is dependent on the company’s growth trajectory and, most importantly, which VC backs them.
While commercial loans are underwritten to cash flows or assets, venture debt is dependent on the company’s growth trajectory and, most importantly, which VC backs them.
Startups then repay the loan via the company’s cash position or the loan is refinanced when the next round of financing is raised.
The benefits of venture debt
While some founders may hesitate to take on a loan, there are some benefits to venture debt worth considering:
1. Extends cash runway
Venture debt bolsters the balance sheet of a startup and can extend the cash runway. This grants the company some breathing room to reach critical revenue and growth goals.
2. Funds the company’s growth with minimal dilution
Venture debt financing is underwritten as debt with a nominal warrant position (in contrast to equity capital that is a direct share purchase).
3. Only pay interest on drawn principal
A startup can choose to treat venture debt as insurance and refrain from using it unless it’s absolutely necessary. The upside is interest is only charged on the principal that is drawn.
What do venture debt lenders look for?
Not every tech startup is the right fit for venture debt. Lenders perform a thorough review of a company when determining whether to offer venture debt financing, and is based on a few important factors:
Nature of the company
Venture debt lenders gauge whether the business has the profile of a scalable technology company. Such criteria may include:
- Whether the startup is IP-driven.
- Does it have a scalable business model?
- Semblance of product market fit
- Is there a meaningful market size?
Metrics and performance
Lenders analyze the company to fully understand its performance. Some questions they may ask:
- Has it grown, or is it planning to grow, at a venture-grade pace?
- Does the cash-burn indicate that venture debt will meaningfully help the company?
- Is there a measure of capital efficiency in the business (i.e., does the company have enough capital to reach the next round of financing)?
Strength of investor suite
- Will the lead investor make sequential investments?
- What is the size and vintage of the lead investor’s fund?
- The historical performance of the VC, as this is also an indicator of the startup’s potential from an equity perspective.
Recent equity raise
A startup should have an existing cash runway of more than 12 months before talking to a venture debt lender. The best time to qualify for venture debt is shortly after a venture capital equity raise.
How venture debt is structured
Underwriting teams conduct due diligence to develop a solution that fits the unique needs of the company. Understanding how the company grows (not just that it is growing) is critical to the process. When determining how to structure a company’s venture debt, there are three main considerations:
The size of the loan is typically a function of the business’s equity raise—around 20 to 40 per cent of the latest equity round size.
Meaningful size
The size of the loan is typically a function of the business’s equity raise—around 20 to 40 per cent of the latest equity round size. The intention is to bolster the equity round by an amount that’s meaningful enough to provide the company extra time to reach specific milestones. For example, if a company receives 18 months of runway from an investment round and is required to reach a critical milestone within that period, an injection of venture debt allows more time to reach the goal. Lenders generally provide enough venture debt for three to six months of cash runway. If a company burns $500K per month, a lender may size a facility (loan) at $1.5 to $3 million, depending on the round size and lead investor’s investment.
Term length
The loan term is typically less malleable than sizing. Lenders want to provide enough time to avoid burdening companies with excessive payments while also minimizing their own risk exposure. Since it’s difficult to predict how a startup company will look 10 years ahead, lenders tend to keep the loan term relatively short. In the broader venture debt market, average tenure for a facility is around four years.
Pricing
Pricing is a major consideration of venture debt, and has two components: interest rate and the warrant position. The interest rate is usually a margin above the prime rate but is only applied to the amount the company draws upon.
What is a warrant?
In venture debt, the warrant is a nominal equity option that the company gives to the lender. A warrant gives the investor the right to buy company shares in the future at a pre-established price. Because the investor has the potential to share in the company’s future success, this feature aligns both the lender and the startup on its growth. These warrant positions are much smaller than the facilities themselves (in the realm of basis points), meant to align on growth without diluting the company like equity capital.
What to know when considering venture debt for your startup
Not all venture debt lenders are the same, so it’s important to carefully consider all your options. You’re entering into a partnership and, ideally, you want to stay with that lender for as long as you can. Is the lender able to scale with you? Do your long-term needs and the lender’s capabilities match?
Familiarize yourself with the lender’s approval process to understand how they get their deals done. Consider asking how often you’ll communicate. Pricing and diligence are especially important. Some providers may label their solutions as venture debt but have minimal diligence, an unreasonably high interest rate, and no warrant position to incentivize them to help you grow. Working with a law firm experienced in venture debt is recommended given the complexity of this debt instrument.
RBCx offers venture debt financing designed for tech startups in every growth stage that minimizes dilution to founders and early investors. We back some of Canada’s most daring tech companies and idea generators, turning our experience, networks, and capital into your competitive advantage to help drive lasting change. Speak with a RBCx Technology Advisor to learn more about how we can help your business grow.
